Financial Stability
New threats

The international financial system has been subjected to severe shocks in the 1980s. Although 1930s-style financial crises have so far been avoided, stability in the 1980s is nevertheless precarious, Alexander Swoboda told a lunchtime meeting on 6 July. Increasing integration and the rapid pace of innovation in global financial markets meant that threats to stability were very different in the 1980s. Escalation of exchange controls and trade restrictions had been avoided so far in the 1980s, but continued macroeconomic policy conflict among the major industrial nations could trigger a repeat of the 1930s crises. International coordination of fiscal policy, Swoboda argued, would leave monetary policy freer to achieve the exchange and interest rate stability necessary to international financial stability.

Alexander K Swoboda is Professor at the Graduate Institute of International Studies and Director of the International Center for Monetary and Banking Studies (ICMBS) in Geneva. He spoke at a lunchtime meeting marking the July 9 publication of Threats to International Financial Stability by Cambridge University Press. The volume, edited by Swoboda and Richard Portes, is based on a conference held in September 1986 and organized by the ICMBS in association with CEPR. It brought together a leading group of economists, policy-makers and bankers to analyse new threats to stability and to consider policies to contain them.

A clear definition of a financial crisis was needed first, Swoboda noted. Barry Eichengreen and Richard Portes, in their contribution to the volume, characterized a financial crisis in terms of plummeting asset prices and a disruption of the system's ability to allocate capital. Whether shocks to the system will precipitate a full-fledged crisis depends partly on whether linkages between various asset markets tend to amplify the shocks: the linkages between exchange-market disturbances, debt defaults and bank failures were crucial in this respect. Eichengreen and Portes found striking similarities between the 1929-35 and 1979-85 crises. In both cases debt repayment problems manifested themselves in Latin America and in Central Europe and can be attributed at least partly to falling commodity prices and waning demand by the major industrial economies. But the linkages identified by Eichengreen and Portes have not operated in the same destructive fashion in the 1980s: in particular, the banking system has been protected and financial crises have been avoided.

Swoboda also drew attention to the analysis of contagion effects by Anthony Saunders, which helped explain the stability of the banking system and why the 1980s shocks have not triggered financial crises. Saunders examined interest rate spreads in international deposit and loan markets, bank equity returns, and credit rationing and bank runs. These revealed little evidence of contagion effects in the post-1970 period except, mildly and briefly, around major crises such as Herstatt, the Mexican debt crisis, and Continental Illinois. Moreover, these effects seem to have weakened after 1982. The existence of implicit or explicit guarantees by regulators may help explain the absence of contagion, Swoboda concluded.

There was no room for complacency, however. Swoboda argued that increasing global integration and the pace of innovation in financial markets presented new threats to stability in the 1980s. Settlement risk in the interbank market presented a serious problem. Simulations undertaken at the New York Federal Reserve indicated the fragility of the Clearing Houses Interbank Payments System (CHIPS). The failure of one large CHIPS participant to settle its net position at the end of one day would result in some 50 banks (or slightly less than half the CHIPS participants) having settlement obligations in excess of their capital: they would be (technically) insolvent. One suggestion to meet this threat is made in the volume by Arturo Brillembourg and by Richard Zecher. The payments and settlements function could be separated from the other activities of the banking system. The former would be tightly regulated in exchange for explicit guarantees of the integrity and soundness of the payments and settlements system. Other activities of banks would be subject only to minimal supervision, and it would be left to markets to discipline these activities.

The deterioration in the quality of bank asset portfolios had also given rise to concern, Swoboda noted. This deterioration was in part due to the increasing use of direct finance in securities markets, which could make banks much more susceptible to contagious runs. It was all the more important therefore to measure the riskiness of bank portfolios accurately. The chapter by Stephen Schaefer shows the need for better methods of risk measurement. Schaefer shows that there is a wide divergence between the measure of riskiness used by the Bank of England and a measure suggested by the theory of finance.

Policy conflict among the major industrial countries could trigger an eruption of exchange and trade controls or a currency crisis, as it did during the 1930s, Swoboda warned. An open trade and financial system is essential for financial stability. This is at present threatened by mounting protectionist pressures, partly motivated by large and persistent current account imbalances among the industrial countries.

Swoboda discussed his recent research with Hans Genberg, which indicated that the coordination of fiscal policies is particularly important if current account balance and growth in the world economy are to be achieved simultaneously. Genberg and Swoboda argue that the ratio of the US budget deficit to that of the rest of the world plays a crucial role in determining the current account, while the sum of the two blocs' net fiscal expenditures is important for world growth and employment. More appropriate fiscal balance, involving a reduction in the US budget deficit and greater spending elsewhere, would free monetary policies to achieve the interest and exchange rate stability necessary for regulatory reforms. These in turn could help achieve both more stability and efficiency in the international financial system.
The discussion which followed touched on a number of issues, such as the growth of direct finance in securities markets. If corporations resorted to such means of finance and then experienced difficulties, banks might be unwilling to help. Portes thought that a return to 'relationship' banking was likely. Swoboda argued that the 1970s witnessed exceptional levels of intermediation by banks: the growth of direct finance in the 1980s might therefore be merely a return to normal. The exchange by banks of equity for LDC debt was also discussed. Portes noted that it had occurred on only a small scale so far and largely involved the exchange of bank debt for physical assets in the LDCs. The process resembled barter trade and was subject to similar distortions and limitations.

Threats to International Financial Stability is available from Cambridge University Press in hardcover (ISBN 0 521 34556 1) at #27.50/$42.50 and in paperback (ISBN 0 521 34789 0) at #9.95/$16.95. Orders must be placed with CUP: a form is enclosed with this Bulletin.